Accounting Chapter 8

Financial Accounting Fifth Edition
Current Liabilities
CHAPTER
8 Spiceland • Thomas • Herrmann
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Part A
CURRENT LIABILITIES
Learning Objective 1
LO8–1 Distinguish between current and long-term

liabilities.
Liabilities
• Liabilities have three essential characteristics.
 probable future sacrifices of economic benefits,
 arising from present obligations to other entities,
 resulting from past transactions or events.
• Recall that assets represent probable future benefits. In
contrast, liabilities represent probable future sacrifices
of benefits.
• What benefits are sacrificed?
 Most liabilities require the future sacrifice of cash
(accounts payable, notes payable, and salaries payable).
 Deferred revenue is a liability that requires giving up
inventory or services.
Current vs. Long-Term Liabilities
Current Long-Term
• Usually payable within • Payable in more than one
one year from the balance year from the balance
sheet date sheet date
Operating cycle: The time it takes to produce revenue.
If a company has an operating cycle longer than one year, its current liabilities are
defined by the operating cycle rather than by the length of a year.
For some companies (a winery, for example), it takes longer than a year to
perform the activities that produce revenue.
A company with a 3-month operating A company with a 15-month operating

cycle would classify current liabilities cycle would classify current liabilities as
as those due within one year. those due within 15 months.
Illustration 8–1
Risk Factors of United Airlines
UNITED AIRLINES
Management Discussion and Analysis (excerpt)
Stagnant or weakening global economic conditions either in the United States or
in other geographic regions, and any future volatility in U.S. and global financial
and credit markets may have a material adverse effect on the Company’s
revenues, results of operations and liquidity.
Additional terrorist attacks, even if not made directly on the airline industry, or
the fear of or the precautions taken in anticipation of such attacks (including
elevated national threat warnings or selective cancellation or redirection of
flights) could materially and adversely affect the Company and the airline
industry. Wars and other international hostilities could also have a material
adverse impact on the Company’s financial condition, liquidity and results of
operations.
Illustration 8–2
Current Liabilities Section for
Southwest Airlines
SOUTHWEST AIRLINES
Balance Sheet (partial)
($ in millions)
Current liabilities:
Accounts payable $1,178
Accrued liabilities 1,985
Air traffic liability 3,115
Current maturities of long-term debt 566
Total current liabilities $6,844
Concept Check 8–1
Which of the following is typically considered a
current liability?
a. Salaries payable
b. Prepaid insurance
c. Mortgage payable due in 30 years
d. Accounts receivable
Current liabilities are payable within one year. Salaries
payable are generally paid in less than a year. Prepaid
insurance and accounts receivable are assets, and the
mortgage payable due in 30 years is a long-term liability.
LO8–2 Account for notes payable and interest

expense.
Notes Payable
• Note signed by a firm promising to repay

the amount borrowed plus interest
• Interest on notes is calculated as:
Face Annual Fraction

Interest = value × ×
interest rate of the year
Recording Notes Payable
Assume Southwest Airlines borrows $100,000 from
Bank of America on September 1, 2021, signing a 6%,
six-month note.
September 1, 2021 Debit Credit

Cash …………………………………………. 100,000
Notes Payable …………….......... 100,000
(Issue notes payable)
Recording Interest Payable and
Repayment of Notes Payable
Interest for full term of loan: $100,000 x 6% x 6/12 = $3,000
• Year-end adjusting entry for interest payable
Sept. 1 to Dec. 31
December 31, 2021 Debit Credit
Interest Expense (= $100,000 × 6% × 4/12) … 2,000
Interest Payable ……………........................ 2,000
(Record interest incurred, but not paid)
• Repayment of note
March 1, 2022 Jan. 1 to Mar. 1 Debit Credit
Notes Payable (face value)………………..………... 100,000
Interest Expense (= $100,000 × 6% × 2/12) … 1,000
Interest Payable (= $100,000 × 6% × 4/12) …. 2,000
Cash……………........................................... 103,000
(Pay notes payable and interest)
Key Point
We record interest expense in the period in
which we incur it, rather than in the period in
which we pay it.
Concept Check 8–2
On October 1, a company signs a $10,000, 5%, 6-
month note payable. How much interest would be
recorded by December 31 of the same year?
a. $250
b. $125
c. $500 Interest is recorded for the period from the
d. $0 date of the signing of the note (10/1) to the
end of the fiscal year (12/31). The amount
recorded for three months is:
Interest = $10,000 × 5% × 3/12 = $125
Line of Credit & Commercial Paper
• Line of credit:
 Informal agreement
 Permits a company to borrow up to a prearranged
limit
 Recorded similar to notes payable
• Commercial paper:
 Borrowing from another company rather than a bank
 Sold with maturities ranging from 30 to 270 days
 Interest rate is usually lower than on a bank loan
Key Point
Many short-term loans are arranged under an

existing line of credit with a bank, or for larger
corporations in the form of commercial paper, a
loan from one company to another.
Accounts Payable
• Amounts owed to suppliers of merchandise or
services
• Sometimes called trade accounts payable
• Most accounts payable are current liabilities,
but they could be long-term liabilities,
depending on the due date.
LO8–3 Account for employee and employer payroll

liabilities.
Illustration 8–3
Payroll Costs for Employees and
Employers
Employee Costs Employer Costs
• Federal and state income taxes • Federal and state unemployment taxes
• Employee portion of Social Security • Employer matching portion of Social
and Medicare (FICA taxes) Security and Medicare
• Employee contributions for health, • Employer contributions for health,
dental, disability, and life insurance dental, disability, and life insurance
• Employee investments in retirement • Employer contributions to retirement
or savings plans or savings plans
Employee Costs
• Federal and state income taxes
• FICA taxes
 7.65% (6.2% + 1.45%)
 Collectively, Social Security and Medicare taxes
• Employees may have additional amounts
withheld from their paychecks for health,
dental, disability, and life insurance
• Employees may also have amounts deducted
for retirement or employee savings plans
Employer Costs
• Additional (matching) FICA tax on behalf of
the employee
• Employers also pay federal and state
unemployment taxes on behalf of employees
 FUTA and SUTA
• Fringe benefits: Additional employee benefits
paid for by the employer
 Health, dental, disability, and life insurance
 Contributions to retirement or savings plans
Illustration 8–4
Payroll Example, Hawaiian Travel
Agency
Hawaiian Travel Agency has a total payroll for the month of January of $100,000
for its 20 employees. Details are provided below:
Federal and state income tax withheld $24,000

Health insurance premiums (Blue Cross) paid by employer 5,000
Contribution to retirement plan (Fidelity) paid by employer 10,000
FICA tax rate (Social Security and Medicare) 7.65%
Federal and state unemployment tax rate 6.2%
Record employee salary expense and withholdings

January 31 Debit Credit
Salaries Expense …………………...……..….….….…….. 100,000
Income Tax Payable ……………………………………. 24,000
FICA Tax Payable (= 0.0765 × $100,000) ……… 7,650
Salaries Payable (to balance) ………………………. 68,350
(Record employee salary expense and withholdings)
Recording Employer-Provided
Fringe Benefits
Record employer-provided fringe benefits

Salaries Expense (fringe benefits) ...….….….… 15,000
Accounts Payable (to Blue Cross)…………… 5,000
Accounts Payable (to Fidelity) ………………… 10,000
(Record employer-provided fringe benefits)
Recording Employer Payroll Taxes

Record employer payroll taxes

December 31 Debit Credit
Payroll Tax Expense (total) ...….….….…………………….. 13,850
FICA Tax Payable (= 0.0765 × $100,000) ……………. 7,650
Unemployment Tax Payable (= 0.062 × $100,000) 6,200
(Record employer payroll taxes)
Common Mistake
Many people think FICA taxes are paid only by
the employee. The employer is required to
match the amount withheld for each employee,
effectively doubling the amount paid into Social
Security.
Key Point
Employee salaries are reduced by withholdings
for federal and state income taxes, FICA taxes,
and the employee portion of insurance and
retirement contributions. The employer, too,
incurs additional payroll expenses for
unemployment taxes, the employer portion of
FICA taxes, and employer insurance and
retirement contributions.
Concept Check 8–3
Which of the following items is paid solely by the
employer?
a. Federal and state income taxes on employees’
wages
b. Social Security taxes
c. Federal and state unemployment taxes
d. Medicare taxes
Companies are required by law to withhold federal and state income taxes
from employees’ paychecks. Employers are also required to withhold Social
Security and Medicare taxes from employees’ paychecks. In addition,
employers may withhold optional deductions, such as medical insurance
premiums, contributions to retirement programs, and other fringe benefits.
Unemployment taxes are NOT withheld, because they are paid solely by the
employer.
LO8–4 Explain the accounting for other current

liabilities.
Other Current Liabilities
• Deferred revenues: liability account used to
record cash received in advance of the sale or
service
• Sales tax payable: sales taxes collected from
customers by the seller
• Current portion of long-term debt: debt that
will be paid within the next year
Illustration 8–5
Revenue Recognition Policy of
United Airlines
UNITED AIRLINES
Notes to the Financial Statements (excerpt)
Revenue Recognition—The company records passenger ticket sales and tickets

sold by other airlines for use on United as passenger revenue when the
transportation is provided. The value of unused passenger tickets is included in
current liabilities as Advance ticket sales.
Example
Deferred Revenues
• When a company receives cash in advance, it debits Cash and
credits Deferred Revenue, a current liability account
• Assume Apple sells iTunes gift cards to a customer for $100
Debit Credit
Cash ………………………………………………….. 100
Deferred Revenue ……………………… 100
(Receive cash for gift card)
• When the customer purchases and downloads, say, $15 worth

of music, Apple records the following:
Debit Credit
Deferred Revenue ……………………………… 15
Sales Revenue …………………………….. 15
(Record revenue for music downloaded)
Example
Sales Tax Payable
• In some states, companies are required to collect sales tax when
selling goods or services and then remitting those back to the
state or local government
• The collection of cash from the customer creates a liability for
the company
• Assume you buy lunch in the airport for $15 plus 10% sales tax.
The airport restaurant records the journal entry as shown.
Debit Credit
Cash ……………………………………………….. 16.50
Sales Revenue …………………….…….. 15.00
Sales Tax Payable (= $15 × 10%)… 1.50
(Record sales and sales tax)
Key Point
Sales taxes collected from customers
by the seller are not an expense.
Instead, they represent current
liabilities payable to the government.
Current Portion of Long-Term Debt
• Debt that will be paid within the next year
• For example, a 20-year mortgage is split and reported
as the portions that are due:
1. Within the next year (current liability)
2. After the next year (long-term liability)
• Long-term obligations are reclassified and reported as
current liabilities when they become payable within
the upcoming year
• For example, a note payable that matures in 10 years
is reported as a long-term liability for the first 9 years,
but as a current liability in the tenth year
Illustration 8–6
Current Portion of Long-Term Debt
SOUTHWEST AIRLINES
Balance Sheet (partial)
($ in millions)
Current liabilities:
Current maturities of long-term debt $ 566
Long-term liabilities:
Long-term debt less current maturities 2,821
Total borrowings $3,387
Concept Check 8–5
A home improvement store sells some merchandise
to a customer. The price of the merchandise is $200
and the sales tax rate is 6.5%. How much would be
recorded in the sales tax payable account?
a. $13.00
b. $213.00 Sales tax payable at the time of
c. $130.00 the sale would be computed as
the price of the merchandise
d. None of the above multiplied by the sales tax rate.
In this case:
$200 × 0.065 (or 6.5%) = $13.00
Part B
CONTINGENCIES
LO8–5 Apply the appropriate accounting treatment

for contingencies.
Contingent Liabilities
An existing uncertain situation that might result
in a loss depending on the outcome of a future
event
Illustration 8–7
Criteria for Reporting a Contingent Liability
1. The likelihood of payment is
a. Probable—likely to occur;
b. Reasonably possible—more than remote but less than
probable; or
c. Remote—the chance is slight.
2. The amount of payment is
a. Reasonably estimable; or
b. Not reasonably estimable.
A contingent liability is recorded only if:

1. A loss is probable and,
2. The amount is reasonably estimable
Illustration 8–8
Accounting Treatment of
Contingent Liabilities
Amount of payment is:
Likelihood of Reasonably Not Reasonably

payment is: Estimable Estimable
Probable Liability recorded Disclosure required

Reasonably possible Disclosure required Disclosure required
Remote Disclosure not required Disclosure not required

Loss………………………………….…………………………. 100
Contingent Liability …………….................... 100
(Record a contingent liability)
Illustration 8–9
Disclosure of Contingencies by
United Airlines
UNITED AIRLINES
Notes to the Financial Statements (excerpt)
Legal and Environmental Contingencies. The Company has certain contingencies

resulting from litigation and claims incident to the ordinary course of business.
Management believes, after considering a number of factors, including (but not
limited to) the information currently available, the views of legal counsel, the
nature of contingencies to which the Company is subject and prior experience,
that the ultimate disposition of the litigation and claims will not materially affect
the Company’s consolidated financial position or results of operations. The
Company records liabilities for legal and environmental claims when a loss is
probable and reasonably estimable.
Accounting for Warranties
Assume warranty costs are estimated to be 3% of sales. December sales are $1.5
million and customers make warranty claims of $12,000 in January of the
following year.
Warranty Expense……………….…………………... 45,000
Warranty Liability …………….................... 45,000
(Record liability for warranties) (45,000 = $1.5 million × 3%)

Warranty Liability……………….………………… 12,000
Cash ……………...................................... 12,000
(Record actual warranty expenditures)
Warranty Liability
45,000 Estimated expense
Actual payment 12,000
33,000 Final balance
Common Mistake
Some students think the balance in the
Warranty Liability account is always equal to
Warranty Expense. Remember, the Warranty
Liability account is increased when the
estimated warranty liability is recorded, but
then is reduced over time by actual warranty
expenditures.
Concept Check 8–6
Which of the following statements is true with
respect to warranty liabilities?
a. Warranty expense needs to be recorded in the
period the warranty repair is made.
b. The warranty expense account balance will
always equal the warranty liability account
balance.
c. The warranty liability account is debited as
actual repairs are made.
d. All of the above are true.
The warranty expense needs to be recorded in the same accounting period that the
sale is made. The warranty expense account is rarely equal to the warranty liability
account. The warranty liability is increased when the estimated liability is recorded
and reduced over time (by a debit) for the actual warranty expenditures.
Concept Check 8–7
During its first year of business, Oceanic, Inc. has
sales of $300,000 and pays warranty claims of
$10,400. Oceanic offers a one-year warranty and
anticipates that warranty costs will total 5% of sales.
What is the balance in Oceanic’s Warranty Liability
account at the end of the first year?
a. $15,000 The estimated amount of total warranty
b. $4,600 expense is $300,000 × 5% = $15,000. Since
payments of $10,400 were made during the
c. $25,400 year, the remaining warranty costs estimated
d. $20,800 to occur next year is:
$15,000 – $10,400 = $4,600.
The Warranty Liability account will have a
balance of $4,600 at the end of the first year.
Contingent Gains
• An existing uncertain situation that might
result in a gain
• In a lawsuit, the defendant faces a contingent
liability, while the other side—the plaintiff—
has a contingent gain
• Contingent gains are not recorded until the
gain is certain
 Example of conservatism
Key Point
Unlike contingent liabilities, contingent gains are
not recorded until the gain is certain and no
longer a contingency.
Analysis
LIQUIDITY ANALYSIS
LO8–6 Assess liquidity using current liability ratios.
Liquidity Analysis
• Liquidity: refers to having sufficient cash or
other current assets to pay currently maturing
debts
• Lack of liquidity can result in financial
difficulties or even bankruptcy
• Three liquidity measures:
 Working capital
 Current ratio
 Acid-test ratio
Working Capital
Working capital = Current assets − Current liabilities
• Measure of current assets remaining after paying
current liabilities
• A large positive working capital is an indicator of
liquidity
• Not the best measure of liquidity for comparing
across companies, because the ratio does not control
for the relative size of each company
Current Ratio
Current assets
Current Ratio =
Current liabilities
• The amount of current assets available for every
$1 of current liabilities
• The higher the current ratio, the greater the
company’s liquidity
• A current ratio of, say, 1.5 indicates that for every
dollar of current liabilities, the company has $1.50
of current assets
Common Mistake
As a general rule, a higher current ratio is better.
However, a high current ratio is not always a
positive signal. Companies having difficulty
collecting receivables or holding excessive
inventory will also have a higher current ratio.
Managers must balance the incentive for strong
liquidity (yielding a higher current ratio) with the
need to minimize levels of receivables and
inventory (yielding a lower current ratio).
Acid-Test Ratio
Cash + Current investments
+ Accounts receivable
Acid-test ratio =
Current liabilities
• The amount of “quick assets” available for every $1 of
current liabilities
• Quick assets are current assets more readily
convertible to cash
 Exclude current assets such as inventory and prepaid rent
• By excluding less liquid current assets, the acid-test
ratio may provide a better overall indication of a
company’s liquidity
Key Point
Working capital is the difference between
current assets and current liabilities. The current
ratio is equal to current assets divided by
current liabilities. The acid-test ratio is equal to
quick assets (cash, current investments, and
accounts receivable) divided by current
liabilities. Each measures a company’s liquidity,
its ability to pay currently maturing debts.
Concept Check 8–8
The current ratio is:
a. Computed as the difference between current
assets and current liabilities
b. Computed as current assets divided by current
liabilities
c. A measure of profitability
d. All of the above
The current ratio is calculated by dividing current assets
by current liabilities. It is a measure of liquidity (not
profitability).
Illustration 8–10
Effect of Various Changes on the
Liquidity Ratios
Changes that Changes that
Increase the Decrease the
Ratio Ratio
• Increase in •Decrease in
Current Ratio
current assets current assets
•Decrease in •Increase in
current current
liabilities liabilities
Acid-Test Ratio •Increase in •Decrease in

quick assets quick assets
•Decrease in
•Increase in
current
current
liabilities
liabilities
Liquidity Management
• Management can influence the ratios that
measure liquidity to some extent.
• Example: A company can influence the
timing of inventory and accounts payable
recognition by asking suppliers to delay
delivery schedules from December to
January. This would reduce the balances in
inventory and accounts payable, thus
changing the current ratio.
Example of Liquidity Management
• Expected End of Period Current Ratio =
$5 mil. / $4 mil. = 1.25
• Company decides to delay receipt of $1
million in goods until the following
period.
• Current assets and current liabilities are
now $1 million lower.
• New Current Ratio: $4 / $3 = 1.33
End of Chapter 8

Accounting Chapter 8

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Accounting Chapter 8

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Financial Accounting Fifth Edition

8 Spiceland • Thomas • Herrmann

LO8–1 Distinguish between current and long-term

A company with a 3-month operating A company with a 15-month operating

LO8–2 Account for notes payable and interest

• Note signed by a firm promising to repay

Face Annual Fraction

September 1, 2021 Debit Credit

Interest = $10,000 × 5% × 3/12 = $125

Many short-term loans are arranged under an

LO8–3 Account for employee and employer payroll

Federal and state income tax withheld $24,000

Record employee salary expense and withholdings

Record employer-provided fringe benefits

Federal and state income tax withheld $24,000

Record employer payroll taxes

LO8–4 Explain the accounting for other current

Revenue Recognition—The company records passenger ticket sales and tickets

• When the customer purchases and downloads, say, $15 worth

$200 × 0.065 (or 6.5%) = $13.00

LO8–5 Apply the appropriate accounting treatment

A contingent liability is recorded only if:

Likelihood of Reasonably Not Reasonably

Probable Liability recorded Disclosure required

December 31 Debit Credit

Legal and Environmental Contingencies. The Company has certain contingencies

January 31 Debit Credit

LO8–6 Assess liquidity using current liability ratios.

Acid-Test Ratio •Increase in •Decrease in

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